Committee for a Responsible Federal Budget

New Discussions on a Carbon Tax

Jul 2, 2015 | Taxes

The Tax Policy Center (TPC) recently released a primer on carbon taxes. The report outlines how the construction of a carbon tax matters for its efficacy in reducing emissions, overall impact on economic well-being, and distributional impact. Particular focus is given to analyzing the potential winners and losers under a carbon pricing regime and how the revenue generated by the tax can be used to alter these effects. Conveniently, the report comes on the heels of a new carbon tax bill (described below) and new research released by CBO, which forecasts hurricane damage to rise five-fold by 2075 as a result of climate change.

Why a Carbon Tax?

TPC argues that a market-based approach is best for reducing greenhouse gas emissions, mainly because emissions arise from millions of activities and this makes it very difficult and costly to achieve emissions reductions through direct regulation. In contrast, they note that putting a price on carbon should facilitate emissions reductions at the lowest cost and encourage innovation, whereas direct regulation does little to reward innovation beyond regulatory minimums. The report notes that countries using carbon taxes and cap-and-trade systems have achieved emissions reductions and compositional changes in their energy industries.

Basic Design Issues

The report discusses the two main decisions that need to be made in the design of any new tax: what to tax and at what rate to tax it. TPC says that “for both efficiency and fairness, a tax should apply as broadly as feasible to all greenhouse gas emissions, regardless of source”. With respect to the rate, the report notes that the tax rate should theoretically be set equal to the damage that results from greenhouse gas emissions, the ‘social cost of carbon’, but acknowledges that estimates of this are extremely uncertain and contentious. The report does argue that even if the rate is set below the social cost, it is important to establish the principle and pave the way for more aggressive future action.

What to Do With the Additional Revenue

A carbon tax has the potential to raise a significant amount of revenue and decisions about what to do with this revenue have a significant impact on the political feasibility of any proposed bill.

One option would be to use the proceeds from the carbon tax for deficit reduction. Using estimates from the Congressional Budget Office (CBO), TPC estimates that a carbon tax of $25 per ton (increasing 2 percentage points above inflation yearly), would raise $1.2 trillion over ten years (0.5 percent of GDP).

While it would be productive to use the carbon tax revenue to reduce deficits, that may not be politically palatable; thus, carbon tax legislation would likely include significant offsetting tax cuts or other spending increases. They outline four potential revenue options: refundable credits, payroll tax cuts, corporate tax cuts, and individual income tax cuts. There are tradeoffs to each: while the credits and payroll tax cuts would offset the regressive nature of the carbon tax, the corporate and individual income tax cuts would better boost economic growth.

The Distributional Effects of a Carbon Tax and Recycling Options

Source: TPC Report

Importantly, any plan that involves offsetting increased revenue needs to consider the long-term trajectory of both carbon tax revenues and the taxes that they are replacing. The report notes that a deficit-neutral policy in the ten-year budget window may have a different effect over the long term. An ostensibly deficit-neutral plan that aggressively reduces carbon emissions would eventually have declining revenue, which paired with expensive tax cuts could increase long-term deficits.

A Carbon Tax Proposal in Congress

TPC's report comes shortly after Senators Sheldon Whitehouse (D-RI) and Brian Schatz (D-HI) introduced a carbon tax bill. The American Opportunity Carbon Fee Act aims to lower US carbon emissions by at least 40 percent by 2025 compared to 2005 levels. The bill would institute a carbon tax of $45/ton starting in 2016, increasing annually by 2 percentage points above inflation until emissions fall 80 percent below 2005 levels, after which it would be indexed to just inflation. The fee would be imposed on all fossil fuels and non-fossil-fuel-based greenhouse gases that have the potential to contribute to global warming and would be border-adjusted.

According to Whitehouse, the tax is expected to generate around $2 trillion in revenue over 10 years. The bill proposes to offset all of the revenue increases through the following policies:

  • Corporate tax cuts: The corporate tax rate would be reduced from 35 percent to 29 percent.
  • Payroll tax offsets: Workers would receive a refund on their payroll taxes up to $500 (adjusted for inflation).
  • Compensation for retirees, the disabled, and veterans: Beneficiaries of Social Security and veterans’ programs would receive a benefit of $500 annually, adjusted for inflation.
  • Block grants to the states: States would be given “cost mitigation” grants to help mitigate carbon tax-related costs.
Expected Ten-Year Effect Of The Proposed Carbon Tax On The Federal Debt
  (Savings)/Costs
New revenue from levying the tax ~ ($2 trillion)
Lowering corporate taxes ~ $600 billion
Payroll tax offsets > $750 billion
Compensation for retirees and disabled individuals > $400 billion
Block grants to the states $240 billion
Net effect on the debt over ten years ~ $0
Source: Sen. Whitehouse’s remarks at AEI.

A carbon tax can certainly be used as a potential mechanism to spur tax reform that reduces more economically distorting taxes. However, it would be preferable if consideration was given to using some of the revenue to reduce the long-term budget deficit, which itself will have serious consequences in the future. 

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